In Stone v. Ritter, 911 A.2d 362 (Del. 2006), shareholders of AmSouth Bancorporation brought a derivative suit against AmSouth's directors alleging a "classic Caremark claim." Id. at 364. In 2004, AmSouth had paid $50 million in fines and penalties to the federal government to settle criminal and civil charges that the bank had failed "to file 'Suspicious Activity Reports,' as required by the federal Bank Secrecy Act and various anti-money-laundering regulations." Id. at 365. The plaintiffs thereafter brought a derivative claim, seeking to recover the $50 million from the directors. Plaintiffs alleged that "defendants had utterly failed to implement any sort of statutorily required monitoring, reporting or information controls that would have enabled them to learn of problems requiring their attention." Id. at 364.
Plaintiffs failed to make demand on the board of directors prior to filing their lawsuit, claiming that demand should be excused as futile. The Chancery Court disagreed, dismissing the suit on grounds that demand was required. In an en banc opinion authored by Justice Randy Holland, the Supreme Court affirmed. There are many aspects of the opinion worth considering. In a prior post, I addressed the opinion's impact on the so-called "duty" of good faith. Here I address some other important aspects of the decision.
Standard of Demand Futility
The Delaware Supreme Court held that the correct standard for determining whether demand should be excused as futile is that set forth in Rales v. Blasband,634 A.2d 927 (Del.1993). This is consistent with the analysis set out in my Corporation Law and Economics text.
The usual standard of demand futility in Delaware law has three prongs: "The basis for claiming excusal would normally be that: (1) a majority of the board has a material financial or familial interest; (2) a majority of the board is incapable of acting independently for some other reason such as domination or control; or (3) the underlying transaction is not the product of a valid exercise of business judgment." Grimes v. Donald, 673 A.2d 1207, 1216 (Del. 1996). This standard, however, fares poorly with respect the important class of cases in which plaintiff alleges that the board failed to exercise proper oversight. As discussed below, the business judgment rule is inapplicable where the board did not exercise business judgment. Is demand therefore automatically excused in oversight cases? Rales said no and Stone confirms that result.
Affirming Caremark
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In dicta in Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), former Delaware Chancellor Allen held that the fiduciary duty of care of corporate directors included an obligation for directors to take some affirmative law compliance measures. Specifically, the board has a "responsibility to assure that appropriate information and reporting systems are established by management" to ensure that the company complies with the key regulatory regimes under which it operates. Id. at 969-70.
In Stone, the Delaware Supreme Court confirmed that the Caremark dicta is now the law of Delaware: "we hold that Caremark articulates the necessary conditions for assessing director oversight liability." Stone, 911 A.2d at 365.
Reinterpreting Caremark
In Caremark, Chancellor Allen repeatedly referred to the fiduciary duty in question as the duty of care. He also expended considerable analytical effort to determining whether the business judgment rule applied. This made perfect sense.
The business judgment rule is corporate law's central doctrine. It pervades every aspect of the state law of corporate governance, from negligence by directors to self-dealing transactions to termination of shareholder litigation and so on. Properly understood, the rule as an abstention doctrine that creates a presumption against judicial review of duty of care claims. The court will abstain from reviewing the substantive merits of the directors' conduct unless the plaintiff can rebut the business judgment rule by showing that one or more of its preconditions are lacking. Corporation Law and Economics at 243.
One of the preconditions for application of the business judgment rule is good faith. Directors who act in bad faith get no protection from the rule. Another precondition is the absence of self-dealing. Directors who breach the duty of loyalty get no protection from the rule. See, e.g., Bayer v. Beran, 49 N.Y.S.2d 2 (Sup. Ct. 1944) ("The business judgment rule, however, yields to the rule of undivided loyalty. This great rule of law is designed "to avoid the possibility of fraud and to avoid the temptation of self interest.'"). Finally, and most pertinently, the business judgment presumes an exercise of judgment. Directors who fail to make a decision or otherwise exercise business judgment get no protection from the rule. Corporation Law and Economics at 270.
Allen's discussion of these issues in Caremark makes clear that he saw the question of board oversight as one of the duty of care and its corollary business judgment rule. Allen's analysis begins by distinguishing two scenarios in which directors might be sued with respect to the firm's law compliance. First, where the directors made an ill-advised decision, the business judgment rule will insulate that decision from judicial review "assuming the decision made was the product of a process that was either deliberately considered in good faith or was otherwise rational."
Alternatively, however, liability issues also arise where the board failed to act. Allen acknowledged that much of what the corporations does never comes to the board's attention. Allen contended, however, that decisions made deep in the interior of the corporation by relatively junior employees can have devastating consequences. Allen also noted two concurrent regulatory trends. On one hand, federal law increasingly uses criminal sanctions to ensure corporate compliance with various regulatory regimes. On the other, the federal criminal sentencing guidelines mitigate sanctions where the corporate defendant had law compliance programs in place. In light of these considerations, Allen held that a corporate board has an obligation to create information gathering and monitoring mechanisms designed to ensure corporate law compliance.
Here, however, is where things get interesting. Suppose, for example, that the board considered the issue and then affirmatively decided not to adopt a law compliance program. Would it be liable if that decision resulted in corporate losses? In theory, a decision not to act does not differ from a decision to take action. Chancellor Allen said, moreover, that directors who act in good faith through proper procedures are not liable even if, in retrospect, they made the wrong decision. The business judgment rule, as typically formulated, would seem to protect directors who rationally adopt either a minimal compliance program or even no program at all after weighing the costs against the benefits. Cf. Rabkin v. Philip A. Hunt Chemical Corp., 1987 WL 28436 *3 (Del. Ch. 1987) (holding that "a conscious decision as to the types of information provided to the directors would fall within the protection of the business judgment rule as a general matter").
In Stone, however, the Delaware Supreme Court did something very curious. It reinterpreted Caremark as a case in which the operative standards are good faith and loyalty rather than care, stating that "the Caremark standard for so-called 'oversight' liability draws heavily upon the concept of director failure to act in good faith. That is consistent with the definition(s) of bad faith recently approved by this Court in its recent Disney decision, where we held that a failure to act in good faith requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence). In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: ... where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." The Court further explained that such an intentional failure "describes, and is fully consistent with, the lack of good faith conduct that the Caremark court held was a 'necessary condition' for director oversight liability, i.e., 'a sustained or systematic failure of the board to exercise oversight--such as an utter failure to attempt to assure a reasonable information and reporting system exists...." As Eric Chiappinelli recognized, Stone thus is "a significant change in Caremark jurisprudence," although as Gordon Smith points out this change was presaged by an earlier Chancery Court opinion by Vice Chancellor Strine.
Notice how the Stone court thus got it wrong in two distinct ways. First, it seems clear that a conscious decision by the board of directors that the costs of a law compliance program outweigh the benefits will no longer be protected by the business judgment rule. To the contrary, such a decision might result in per se liability. See Stone, 911 A.2d at 370, in which the court stated that "Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith." I suppose this problem could be finessed by holding that a board that consciously decides on the basis of an informed process not to adopt a law compliance program will escape liability because such a board had no "duty to act," but notice how such a solution guts the business judgment rule. The whole purpose of the business judgment rule is to prevent the court from asking whether the board made a reasonable decision. See, e.g., Brehm v. Eisner, 746 A.2d 244 (Del. 2000) ("Courts do not measure, weigh or quantify directors' judgments. We do not even decide if they are reasonable in this context.").
Second, the situation in which Caremark most clearly resulted in liability was where "there was an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss." This is so, Caremark clearly suggests, because the business judgment rule has no application where the board failed to exercise business judgment. The paradigm case for director liability thus was a board, such as the defendant board in Caremark itself, which over a sustained period of time simply failed to even consider whether a law compliance program was necessary. Yet, by requiring "a showing that the directors knew that they were not discharging their fiduciary obligations," the Stone court seemingly would allow such a board to escape liability.
On the other hand, in ATR-Kim Eng Financial Corp. v. Araneta, 2006 WL 3783520, Vice Chancellor Leo Strine recently imposed Stone-based liability on directors where, inter alia, "no reporting system was in place and that no other information systems or controls were ever considered, let alone implemented, by the Delaware Holding Company's board of directors." The issue is confounded in Araneta, however, because Strine also held that the key defendants "behavior was not the product of a lapse in attention or judgment; it was the product of a willingness to serve the needs of their employer," which was the company's controlling shareholder. So the issue of whether liability can be imposed post-Stone solely for a sustained failure to consider the desirability of law compliance programs perhaps remains unresolved.
Both of these results appear to be a logical reading of Stone. Neither result strikes this observer as being consistent with prior Delaware law or even basic common sense.
A Practical Effect
Professor Chiappinelli points out that the practical effect of Stone is to remove "Caremark claims from the ambit of § 102(b)(7) provisions." I think he's right and I think this case is, in part, just one more example of how the Delaware Supreme Court seems determined to gut 102(b)(7) of any utility. More on this later.
In Sum
As a corporation law casebook and treatise author, this is the sort of opinion that drives me crazy. The Supreme Court seemingly set out to solve some doctrinal puzzles, but in doing so made things worse. Lots of questions are thus presented.
Do we move Caremark to the chapter on duty of loyalty? What about other cases, such as Francis v. United Jersey Bank, in which a failure to exercise business judgment led to a duty of care analysis? Should we continue to teach that Delaware law leads to the same result as Francis?
Should we drastically rework the chapter on fiduciary duties to deemphasize care at the expense of loyalty? Increasingly, it seems as though the duty of loyalty is subsuming all the interesting cases. Likewise, the business judgment rule and 102(b)(7) seem increasingly irrelevant to the interesting cases.
What a mess.